Tuesday, August 24, 2010

I am not a client of Rollins Financial, but I have a bond portfolio that I manage myself. Currently, the average interest rate on the bonds within my portfolio is 4%. I have the interest payments mailed directly to me, and I leave all the bonds on deposit at the brokerage house. I have the following questions:

Q. Even though the average rate of return on the bonds is 4%, over the last several years the value of this account has changed dramatically. One year I made 14% on the portfolio (including the interest I received), and another year I lost 20%. What causes such vast fluctuations?

A. First, let’s give a little background on bonds. When bonds are sold to the open market, they are priced at “par” which is typically $1,000. At par, the bond has a set dividend that correlates to the yield that most people reference. For example, a bond paying 4% at par will pay $40 for every share ($1,000 @ 4% = $40). If the bond is priced higher than par, it is being sold at a “premium” and will have a yield less than 4%. If the bond is priced lower than par, it is being sold at a “discount” and will have a yield less than 4%. Whether the bond is being sold at a premium or discount, the dividend amount remains the same.

Bonds are debt instruments used by governments (federal, state, local, and foreign) and corporations to raise money for various reasons. The “bondholder” (one who buys the bond) is considered a creditor. The credit worthiness of the “bond issuer” (the entity issuing the bonds for money) will determine what the yield would need to be for the “market” to purchase the bond. The better credit the issuer has the lower the yield. For instance, the U.S. government will always have the lowest yields then yields will move higher from there. Bond “classes” are generally considered U.S. Treasuries, Investment Grade, and High-Yield. Also, if held to maturity, the bondholder will receive the par value back at maturity.

Now, regarding your question, bonds are generally considered “safer” investment instruments than equities because in the event that an entity goes into bankruptcy, the bondholder would be paid prior to preferred or common stock owners. This does not mean though that bond prices will not fluctuate wildly depending on various factors – economy, interest rates, issuer specific problems, etc.

For example, in 2008 your bond portfolio dropped 20%. While we do not know the specific bonds you hold, it is easy to look back and see that during 2008 the underlying economic fear was that corporations and governments were going to default on their bonds. Since this was the worry, the price the market was willing to pay for bonds (with the exception of U.S. Treasury bonds) dropped dramatically and thus almost all bonds were being sold at a discount.

In 2009, when the market and economy rebounded with companies once again generating profits, bonds started to rise likewise. The fear of defaults that drove the price down subsided and thus pushed the bonds higher.

Below is a chart reflecting the various returns on these separate classes in 2008 and 2009.

Q. What can I do to remove the volatility from this bond portfolio?

A. Simply put – diversification. When designing a portfolio of bonds or equities, it is important to have a mixture of the various styles within the portfolio to balance the different ebbs and flows of the styles.

Bonds have the three basic classes discussed in the answer above, but they also have three different maturities as well – short, intermediate, and long. This creates a “grid” with 9 boxes that is very similar to the grid used when analyzing equities. This grid has been made famous by Morningstar and is called a “Style Box” or “Style Map.”

A good mixture of short, intermediate, and long term bonds from the various classes should give you a better mix and remove some of the volatility. Once again, look at the chart above regarding the performance of the various funds. A portfolio that was diversified would have outperformed any single investment.

Q. My monthly statements reflect that some of the assets are titled "Margin Assets." Since I don't have a margin account and don't want my account to be margined, why are these assets called "Margin Assets"?

A. Some brokerage accounts when initially setup may default to allow the account to be margined. This does not mean that you are margining your account or that you will margin your account, but it is an option.

For example, if you write checks on your account and for some reason forgot to have enough free cash in the account, the ability to margin the assets in the account would be used to pay the check – rather than let it bounce. You can look at it simply as “overdraft protection” in this case. This is something we frequently see, and for our clients, we simply place a trade the next day to cover the margin balance within the account.

Like you, we do not use the margin feature in our clients’ accounts unless a client has specifically asked for us to do so. It is considered a “loan” from the brokerage firm, and they do charge interest on the amount that is margined.

By the way, retirement accounts (IRAs, SEP-IRAs, etc.) and custodial accounts are never marginable.

Q. I have been accumulating statements and trade confirmations from my brokerage house for years and I really don't know what to do with them. Do you have any suggestions on alternative methods of receiving statements and trade confirmations from my brokerage house that would minimize the amount of paperwork I have to maintain?

A. A very good question with an answer that we have been preaching for years… go electronic. Brokerage firms now allow clients to receive statements, confirmations, and even prospectuses by email, and it is an easy process to start. Simply setup a login and password with your brokerage firm, then somewhere in the profile portion of the account it should have a section to change your preferences to receive correspondence via email.

Once you are setup, look online to see how many years of statements and confirmations the brokerage account has for your account. It is usually at least seven years, so you have access at any time to review any of those old statements and print them if you wish. You can then decide what you want to do with your current old statements.

Thanks for your questions. I hope you and our other readers found my answers to be useful. As always, we hope you will keep Rollins Financial in mind when seeking professional investing and financial planning advice.

Today was the final week of this special Q&A series. If you have enjoyed this series and would like to see it become a regular feature on The Rollins Financial Blog, please let us know by emailing us – contact@rollinsfinancial.com.

About Us

Rollins Financial, Inc. is an SEC registered investment advisory firm that was established in Atlanta, Georgia in 1990 by Joseph ("Joe") R. Rollins. Joe along with partners Robert ("Robby") E. Schultz, III and Edward ("Eddie") J. Wilcox offer independent investment management services for individuals, small businesses and
corporations.

Rollins Financial employs various investment strategies depending on the specific objectives of each client. Our independence insures that we are able to provide the most objective investment advice since we receive no compensation from any third parties.

Important Disclosures

The information provided on the Rollins Financial Blog is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor should review a security transaction and investment strategy for his or her own particular situation. Data contained herein is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Where specific advice is necessary or appropriate, consult a qualified tax advisor, CPA, financial planner or investment manager.